Over the past several days, the SEC has issued a flurry of emergency orders in an attempt to calm the financial markets. On September 17, it issued an order imposing new temporary restrictions on all “naked” short selling.1 The following day, it announced a temporary ban on short selling in a designated list of financial stocks2 and imposed new short sale position reporting requirements on large hedge funds and other Form 13F filers.3 Since we first reported these developments,4 the SEC has twice revised its emergency orders to clarify the new rules and provide some limited relief from the most stringent restrictions.5 In this advisory, we summarize the current state of play under SEC’s emergency short sale restrictions and reporting requirements.

In addition to the SEC’s actions, the U.K.’s Financial Services Authority (FSA)6 and securities regulators in a number of other countries7 have taken their own steps to ban or strengthen prohibitions against naked short selling, halt short selling of financial stocks and require the disclosure of short positions.

With All of the Amendments, Where Are We Now?

Naked Short Selling

The SEC’s emergency rules to combat naked short selling apply to all public company securities, became effective at 12:01 a.m. on September 18, and will terminate at 11:59 p.m. on October 1, 2008, unless extended by the SEC. Those rules provide for the following new restrictions:

  •  Hard T+3 Close-Out Requirement; Penalties for Violation Include Prohibition of Further Short Sales, Mandatory Pre-Borrow.

–– The SEC adopted a new temporary rule (Rule 242.204T) requiring that short sellers and their brokerdealers deliver securities by the close of business on the settlement date (three days after the sale transaction date, or T+3) and imposing penalties for failure to do so.

–– If a short sale violates the new close-out requirement, then any broker-dealer acting on the short seller’s behalf will be prohibited from further short sales in the same security unless the shares are not only located but also pre-borrowed. The prohibition on the broker-dealer’s activity applies not only to short sales for the particular naked short seller, but to all short sales for any customer.

  •  Exception for Options Market Makers from Short Selling Close-Out Provisions in Regulation SHO Repealed. The SEC eliminated the options market maker exception from the close-out requirement of Rule 203(b)(3) in Regulation SHO.
  • New Short Selling Anti-Fraud Rule. The SEC also adopted Rule 10b-21, which prohibits any person from submitting “an order to sell an equity security if such person deceives a broker or dealer, a participant of a registered clearing agency, or a purchaser about its intention or ability to deliver the security on or before the settlement date, and such person fails to deliver the security on or before the settlement date.”

The SEC first proposed new Rule 10b-21 in March 2008,8 but had taken no further action on its adoption until issuing this order.

While the SEC expressed hope that these efforts would quell manipulative practices that could lead to further investor loss of confidence in the securities markets, the SEC chose not to revive the “uptick” rule, which had been the SEC’s historic measure for regulating against short sale manipulation. Although a number of commentators are clamoring for reinstatement of the uptick rule, there is no indication that Chairman Christopher Cox is willing to entertain the idea.9

Prohibitions Against Short Selling of Financial Stocks

The SEC’s September 18 emergency order prohibiting all short selling in the financial institutions remains in effect, but has been revised to provide greater clarity and some limited relief from its restrictions.10

  •  Prohibition Against Short Selling in Financial Stocks. Effective as of September 18, 2008, and until 11:59 p.m. on October 2, 2008, all short selling in the stocks of financial services companies is prohibited. While the SEC originally listed 799 companies to which the order applied, some issuers complained about being left off the list of specified issuers. The SEC, responding to these complaints, amended its order to require each national securities exchange or listing market to publish a list of individual financial firms that would be covered by the SEC’s emergency rules.11

 The SEC has provided a number of exemptions and exceptions for

–– short sales effected by market makers, including over-the-counter market makers, as part of a bona fide market making and hedging activity related directly to bona fide market making in (a) derivative securities based on covered financial securities, or (b) exchange traded funds and exchange traded notes of which covered financial securities are a component;12

– short sales resulting from automatic exercise or assignment of an equity option –– held prior to the effectiveness of the SEC’s order due to expiration of the option, and a one-day exemption for options market makers who sell short on September 19 as part of their bona fide market making and hedging activities related directly to market making in equity derivatives;

–– short sales that occur as a result of the expiration of futures contracts held prior to the effectiveness of the SEC’s order; and

–– short sales by the writer of a call option resulting from assignment following exercise of the option.

  •  The SEC has also clarified that its order does not apply to persons that effect sales of covered financial services securities pursuant to Rule 144 of the Securities Act.

SEC Disclosure of Short Positions

The SEC’s September 18 emergency order requiring the weekly disclosure of short positions of institutional money managers on Form SH also remains in effect, but has been revised to address some objections raised in the hedge fund community.

  •  New Daily Short Sale Reporting Obligations. Until October 2, 2008, unless extended by the SEC, any investment manager who filed a Form 13F13 for the calendar quarter ended June 30, 2008, will be required to file a new Form SH on September 29, 2008. Thereafter, a new Form SH must be filed before 5:30 p.m. on the first business day of every calendar week immediately following a week in which the institutional investment manager effected short sales.14 Form SH requires disclosure of the number and value of securities sold short for each Section 13(f) security (except for short sales in options), the opening short position, closing short position, and the amount and time of the largest intraday short position during each day of the prior week. The disclosure requirements will only apply to short sales effected after September 19, 2008, and no filing will be required if the short position constitutes less the 0.25 percent of the issuer’s outstanding shares and the fair market value of the short position is less than $1 million. 
  • Under the most recent amendments to these rules, Form SH filings initially will be non-public, but will become publicly available via the SEC’s EDGAR database two weeks after filing. The SEC also noted that its confidential treatment procedures will not apply to the Form SH.